Does contingent liability affect the stock price?

Stock prices are not only susceptible to external factors like market movement, but also internal ones like a company's financial health (revenue, cost and profits). Another factor which, at first glance, may not seem to have any effect on the share price movement is 'contingent liability'. This is the amount that a company may need to shell out in the future and its loss potential is measured in terms of the probability of those events coming to pass. Such liabilities include pending lawsuits (litigation filed against the company pending with authorities such as the National Consumer Disputes Redressal Commission, consumer dispute forums or civil courts), income tax or sales tax disputes, or patent infringements.

This liability is very different from the fixed liabilities of a company, be it current or long-term, which mature at pre-defined periods. These include bank loans taken by the company to, say, purchase machinery or payable mortgages, bonds and debentures. Any change in the assets and liabilities of a company can have a major influence on the stock price.

For example, an increase in the total debt via enhanced long-term loans of a company can make it susceptible to default. This is because the debt has to be serviced irrespective of whether the company makes profit or suffers losses. A company that is unable to manage its debt level relative to its assets often witnesses investors' wrath.

Given the nature of contingent liabilities, establishing a direct relationship with stock prices becomes very difficult. Consider a company facing a Rs 150 crore lawsuit. If the court's ruling is in favour of the company, there is no liability, but if the judgement swings the other way, the company will take a hit. Since it is difficult to ascertain the outcome beforehand, the company will not mention this potential liability in its balance sheet. In fact, contingent liabilities, as a rule, find mention only in the footnotes or notes to the financial statements section.

So, how does the market treat companies that carry contingent liabilities in their financial statements? Should they be shunned or not? Expert opinion is divided. Says Sachin Shah, fund manager, Emkay Investment Managers Ltd: "Generally, stock price returns are expected to move in sync with the business outlook, profit growth, ratios like return on capital employed (ROCE) and return on equity (ROE), and the size of the company.

So, barring few exceptions, like pharma companies facing litigation, contingent liabilities are not expected to be an overhang on the stock prices or stock returns." However, others believe that a relationship does exist. "Contingent liability is like a time bomb and can be a cause of fear and concern for investors till the liability is crystallised and provided for in the accounts," cautions K Jayaraman, research associate, Bonanza Portfolio Ltd.

Given the ambiguity, ET Wealth decided to do some number crunching and settle the matter. To check whether there is a relationship between stock prices and contingent liability, we studied the books of 1,300 companies (see Methodology).

To begin with, we compared the contingent liability of each company with its revenue or net sales and calculated the ratio by dividing the former with the latter. For example, if a company has a contingent liability of Rs 300 crore and net sales of Rs 3,000 crore, the ratio is 0.1 or 10% of the net sales. On the basis of this ratio, we divided the companies into two groups.

One group had only those companies whose ratio of contingent liabilities to sales had risen consistently in the past five financial years, and the other in which the ratio had fallen consistently in the same time frame. In other words, the first group had companies with rising contingent liabilities and the second included companies with falling contingent liabilities. The next step was to check the average price performance of these two groups between 31 March 2008 and 31 August 2012.

The results were startling. The group with rising contingent liabilities severely underperformed the market and gave a negative average return of 14.22%. During the same period, the BSESensex returned 11.4%. The second group, comprising companies with falling contingent liabilities, outperformed the market and delivered 58.5% returns on an average, more than five times the market return.

While our research clearly established that contingent liabilities and stock prices are correlated, one issue remained unresolved: What is their significance in the valuation of a company? Says P Phani Sekhar, fund manager, PMS, Angel Broking: "Contingent liabilities, by their very nature, present a risk, which can be operational or financial. A realistic assessment of such risks alters the valuation of a company. These liabilities are generally created in industries that are engaged in long gestation projects."